Tax Challenge Pits California Against Amazon

February 26, 2010 4:18 PM ET

Alan Greenblatt

California lawmakers are planning next week to impose a tax on sales conducted through Amazon.com and other major online retailers. They estimate the state could collect as much as $150 million a year. But the reality is that California's not likely to see a penny, at least for a while.

States have been trying for years to find ways to collect taxes from online sales, which continue to grow at a rate of about 10 percent a year. States are now losing out on $20 billion annually in taxes they would be collecting if all online sales were happening in physical stores.

In 1992, the Supreme Court ruled that states could not force retailers to collect sales taxes unless they had "nexus" — a physical presence in a given state. That doesn't apply to operations such as Amazon that don't run physical stores and do all their business online.

But several states have made the argument that major companies such as Amazon and Overstock.com are, in fact, doing business within their borders. They use many local affiliates — companies, reviewers and bloggers within a state that have Web sites directing customers to Amazon or Overstock for purchases.

The affiliates, then, are acting as an in-state sales force, earning commissions for sending along customers. After Rhode Island and North Carolina passed laws testing this theory, Amazon and Overstock simply cut off their dealings with the local affiliates, thus eluding the state tax collectors' clutches.

When New York kicked off this trend by passing a law in 2008, though, Amazon and Overstock both sued in hopes of blocking it. New York was too big a market to surrender by ending affiliate relationships.

California legislators are convinced their state would also be too big to walk away from. Amazon alone has 25,000 affiliates in California.

Amazon has refused to comment on the Sacramento effort. But Overstock President Jonathan Johnson argues it would be illegal.

California legislators face a political challenge that will preclude a real debate about whether their proposal passes constitutional muster. Gov. Arnold Schwarzenegger vetoed a similar bill last year.

Legislators hope that he'll change his mind, given the state's $19 billion budget shortfall. But Schwarzenegger's office has signaled he will not bend.

Schwarzenegger is leaving office at the end of the year and a new governor might sign the next version of the bill. If and when that happens, the online sales tax battle will begin in earnest.

"Online sales are clearly having a detrimental impact," says Jean Ross, executive director of the California Budget Project, a fiscal watchdog group in Sacramento.

"Why would a state give preferential tax treatment to a business that by definition doesn't employ a single person in that state?"